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price mechanism
brings demand and supply into equilibrium, and the 
equilibrium price 
for a good 
is the price at which the volume demanded by consumers and the volume that firms would be willing to 
supply is the same. This is also known as the 
market clearing price
, since at this price there will be 
neither surplus nor shortage in the market.
The way demand and supply interact to come to the equilibrium price can be illustrated by drawing the 
market demand curve and the market supply curve on the same graph (Figure 8). 
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CHAPTER 4
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MICROECONOMIC FACTORS 
 
109 
Price
Quantity
Market
demand
Market
supply
A
B
D
C
P
P
P
1
2
0
Q
Excess supply
Excess demand
Figure 8 Market equilibrium 
Figure 8 shows the planned (or 
ex ante
) demand and planned supply at a set of prices. 
At price P
1
in Figure 8, suppliers want to produce a greater quantity than the market demands, meaning 
that there is excess supply, equal to the distance AB. Suppliers would react as the stock of unsold goods 
accumulates. 
(a) 
They would cut down the current level of production in order to sell unwanted inventories. 
(b) 
They would also reduce prices in order to encourage sales. 
The opposite will happen at price P
2
where there is an excess of demand over supply shown by the 
distance CD. Supply and price would increase. Faced with an excess of demand, manufacturers would 
be able to raise their prices. This would make supplying the good more profitable and supply would 
increase. 
At price P the amount that sellers are willing and able to supply is equal to the amount that customers 
are willing and able to buy. Consumers will be willing to spend a total of (P × Q) on buying Q units of 
the product, and suppliers will be willing to supply Q units to earn revenue of (P × Q). P is the